When capital returns to oil and gas development, where will it go?

The energy world is waiting on pins and needles for the good times to return, or if not on pins and needles then waiting in the bar. The human toll of the downturn has been significant, especially for a generation that hasn’t really seen the down side of the commodity price cycle. Well now they’ve seen it good and hard. The good news is that it is indeed a cycle.

There is a weird consensus out there however that the good times might only come back briefly, just to put in a quick appearance before being hammered down by a flood of US shale production. This view is most visible both in the news and in commodity markets. Futures prices are making a clear statement about the expectation of what’s going to happen should commodity prices rise again – production will flood the market and drive prices back down. Forward prices for 2018-20, for both oil and natural gas, are below current spot prices which is an unusual phenomenon.

It goes without saying that petroleum prices are hard to predict, but the underlying rationale for the opposing arguments seems oddly imbalanced.

On one hand, the camp that thinks oil and gas prices could come back substantially can make a fairly logical argument, with some serious numbers to back them up. Globally, oil and gas capital expenditures have been slashed by hundreds of billions of dollars. Since the oil price crash in 2014, virtually no new major developments have been put into play, and scores have been cancelled. Some megaprojects have come on stream, but those were ones that were initiated well before the price crash. Since that time, the new project pipeline has been near empty.

On the other hand, the camp that believes prices can’t possibly rise relies on some sensational but shaky statistics. And it’s odd that this camp, with their flimsy and localized viewpoint, is defining future prices.

There is therefore a strange loop here that makes the return of the shale boom that much more implausible. Higher prices will allegedly flood the market quickly, which will drive prices back down, all within less than two years according to futures markets. Yet two years isn’t near enough time for such a cycle to unfold. The world produces 95 million b/d, and a 5% decline rate means 2.5 million b/d needs to be replaced every year to keep production flat. That means megaprojects, and more than a few of them.

But these large-scale developments won’t get kicked off with futures prices in the toilet. Historically, forward price curves have simply gone up at some sort of inflationary rate, forming the basis for attracting capital. Now, with forward prices lower, it’s hard to imagine corporate boardrooms rushing to kick off megaprojects when the price received tomorrow will be less than that today.

That lack of these major developments is going to be a problem. The global decline rates mentioned above most likely exceed 5 percent due to the lack of spending. So that means nearly 5 million b/d needs replacing to keep up, every year. That is 1.8 billion barrels per year.

Here’s where it gets interesting. Exploration spending is lower than it has been in more than a decade. Major new discoveries are rare, and were even in the boom times of 4 or 5 years ago. The earth has been scoured, and the easy stuff is found. Is there still oil out there to be discovered? Of course, but it’s $150 oil, not $50 oil.

Now we can turn to what is viewed as the elephant in the room, but is really more of a muskrat – shale oil. The reason for low oil (and natural gas) futures prices over the next 5 years is that the consensus view is that shale oil and gas will flood the market as soon as commodity prices rise slightly. It is most certainly likely that shale fields will spring to life again, but the market thinks of shale production like a 5 year old thinks of a pro wrestler – like he’s the biggest, baddest, strongest guy on earth. The problem is the same in each case – a lack of critical judgement.

Shale oil in the US did double production, adding about 5 million b/d. However, this came at a cost of somewhere between $300 and 500 billion. Despite that vast sum, oil markets start hyperventilating at rising rig counts, nearly wetting themselves when 25 rigs are added to shale development (as happened recently) even though the total US count is a fraction of the boom times of 4 years ago. These simplistic views don’t even notice what’s happening globally. Global rig counts are flat at well under 1,000, exploration is drying up, frontier areas are still to expensive, and the only thing that’s kept the world’s oil supply balanced has been the resurgence of Iranian and Iraqi output. (Saudi Arabia and Russia make all the headlines, but their production has been quite consistent for a number of years, though at record levels.)

So shale output will climb again, perhaps even exceeding its recent peak of about 5 million b/d, reached a year or two ago. But consider over those two years global natural declines will be 5-10 million b/d, depending on decline rates, which is between half and all of US total production. Shale oil is extremely important to the US, but on a global scale it’s actually pretty small (and no other region in the world has gotten very far developing their shale oil prospects; Argentina shows promise but is a long way from making a splash).

To compound the problem, the oil super-majors aren’t all that interested in embarking on major exploration programs. They’re losing their appetite; the fight is just too much. Projects large enough to move the needle have environmental footprints that aren’t socially acceptable anymore. As but one example, Shell is heading for the exit on oil, focusing on natural gas as a clean compromise. Other big oil companies are now grappling with climate change agendas, meaning oil exploration is going to get harder and harder.

Megaprojects are often developed on a 20-30 year time frame. Within that span, there is significant speculation that fossil fuels will be a total pariah (even worse than now). While it is certainly debatable that we’ll be remotely close to living without fossil fuels, the fact remains that capital markets dictate what the big companies will invest in, and few are taking exploration seriously.

Everyone is leaving it to shale oil to save the day, whether it makes sense or not, because the media and markets tell us it will be so. They might be right, but if they’re not, there’s not going to be much to fill the pipes, globally speaking.